Revenues – EBITDA – Cash Flow and SDE
When we value businesses, we often look at them from different angles and use different terms, all in search of a single thing… What’s it worth if I buy or invest? If you have ever looked at a business or investment or spoken to a financial advisor or broker, chances are you have heard the terms revenue, EBITDA, cash flow and SDE thrown around and may have asked yourself what it all means, why they matter, and when they are best utilized. I’ll try to break them down as simply as possible.
Revenue, aka gross revenue, is the easy one… How much money does the business generate? Period. It’s usually presented on an annual basis, although in some cases, it’s broken down further—certainly if it is a seasonal business. Sometimes the value or selling price of a business revolves around this number alone, but usually only when a competitor or very similar enterprise is buying it. They already know the costs involved and just want to fold the added revenue into their model.
EBITDA – It’s an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. While some fancy small business owners and brokers love to use EBITDA, I have always considered it a bit much. Basically, it’s how much money the business is generating, minus expenses, but before factoring in any interest paid on debts, taxes the business pays, and how assets like buildings, vehicles, and equipment are depreciated and amortized. Taxes and interest on debt are fairly easy to calculate, but there are all sorts of ways to finagle depreciation and amortization, so it can often be a great way for some fuzzy math. I’m not alone in that opinion—legends like Warren Buffett tend to agree. The good news is, when it comes to most small businesses, EBITDA is not used very often unless someone is just showing off.
Cash Flow… Cash is king, right? Whether we get there via EBITDA or skip it altogether, we are just trying to get from total revenues to cash flow. How much total revenue does the business generate? How much does it cost to run the business? What’s left over? That’s my cash flow.
If I own a franchise that generates $1M a year, and my cost of goods sold is 40%, payroll is 30%, royalties are 7%, and miscellaneous expenses are 5%, then my cash flow is 18% of $1M, or $180K. Pretty straightforward and simple. I’ve always believed complicated numbers are for job security, not entrepreneurs and investors.
So when looking at a business, you may hear another term: SDE. Another acronym, which stands for Seller’s Discretionary Earnings. SDE is a close cousin to cash flow and, more often than not, comes into play with smaller businesses that have a single owner and no investors. Why? Because it’s my business, my money, and I can run it how I choose.
What if a portion of that 30% payroll cost includes a salary to myself? Or I pay my son $50K a year to take out the trash once a day? Or if my Mercedes is on the books as a company car? What if once a year, I take my business buddies on a lavish golf trip and write it off in my expenses somewhere? These are my prerogative but not exactly necessary to run the business.
When considering buying a business, these are items a new owner may choose to do or not, so most will take these expenses and factor them back into cash flow. We call these add-backs. It’s funny because sometimes sellers disclose this to us with some degree of shame when, in truth, we love them—it’s basically found money that can add value to the business. The IRS may not always feel the same, but that’s not my job.
So there’s an explanation of some of the terms you may hear when looking to buy a business. Best advice: Get the numbers down to where you can explain them using 8th-grade math. That’s what Warren Buffett would tell you.
